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The Economics of the Internet of Things

As everyday objects get connected, brace yourself for network effects, says one economist.

Product companies compete by building ever bigger factories to turn out ever cheaper widgets. But a very different sort of economics comes into play when those widgets start to communicate. It’s called the network effect—when each new user of a product makes its value higher. Think of the telephone a century ago. The greater the number of people who used Bell’s invention, the more valuable it became to all of them. The telephone became a platform for countless new businesses its inventor never imagined.

Now that more objects are getting wired up into networks—street lights, wind turbines, automobiles—there are opportunities for new platforms to emerge. That’s why some companies are seeking the advice of Marshall Van Alstyne, a business professor at Boston University who has studied the economics of e-mail spam and social networks.

These days, Van Alstyne studies “platform economics,” or why companies such as Uber, Apple, and Amazon are so successful—and what traditional product makers can do to emulate them. MIT Technology Review’s senior editor for business, Antonio Regalado, visited Van Alstyne at his office in Boston.

How can I tell if a business is a platform?

If you produce the value, then you are a classic product company. But there are new systems where value is being created outside the firm, and that’s a platform business. Apple gets 30 percent of the cut from other people’s innovations in its app store. I define a platform as a published standard that lets others connect to it, together with a governance model, which is the rules of who gets what. Business platforms are often engaged in consummating a match. It’s a match between riders and drivers with Uber. It’s between travelers and spare capacity of guest rooms in Airbnb.

Is connecting ordinary objects, like toasters, to the Internet going to trigger new platforms?

Absolutely, yes. But you can’t stop at the connectivity. The technologist’s mistake is often to stop simply at the standards, the connections. You also have to add the reasons for other people to add value. That often means allowing recombination of features in ways that you, the original designer, just cannot anticipate. People have combined the functions of the iPhone into hundreds of thousands of apps that Apple never even conceived of. That is also what the Internet of things enables if you design it in the right way.

“Most companies compete by adding new features to products. They haven’t been in the business of thinking of how to add new communities or network effects.”
—Marshall Van Alstyne

What’s an example of this happening?

Philips Lighting just called me. They are adding a series of APIs to their LED lights so anyone can create millions of colors, create romantic mood apps or the colors of a sunset from one of your favorite trips. You can change the lights in your study in conjunction with the stock market conditions. That is the Internet of things, and they’re opening it to anyone (see “The Light Bulb Gets a Digital Makeover”).

Do product companies have a difficult time making this kind of transition?

They have a really difficult time with the mental models. It’s fascinating. Most companies compete by adding new features to products. They haven’t been in the business of thinking of how to add new communities or network effects. One of the points I make is that platform business models are like playing 3-D chess.

You estimate that half the top 20 companies in the world, like Google, own platforms. Why are they winning?

There is a strong argument that platforms beat products every time. Think of how the iPhone is absorbing the features of the voice recorder, the calculator, and game consoles. The reason for this is that as a stand-alone product, you’re going to have a certain pace of innovation. But if you have opened your product so that third parties can add value, and you have designed the rules of the ecosystem such that they want to, your innovation curve is going to be faster.

To me this means there are huge opportunities to take away business from existing players in all different kinds of goods. Or for existing players to expand their markets if they are paying attention.

What are some of the next areas for platforms?

It’s where you see connectivity is coming in. Cities, health care, education, electricity grids.

What are the biggest challenges?

In many cases, the governance models have not been established. For instance, population density can be determined by mobile-phone distribution. A telecom company owns that data. How do you motivate them to share it? All these sensors are capturing data, but how do you divide the value? Those are the rules that need to be worked out, and that’s the missing piece of most of these discussions about the Internet of things. You have to build economic incentives around it, not simply connectivity.

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